Iceland Central Bank Statement

Author: | Published: 5 Sep 2017

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The Icelandic economy is currently booming after a few
years of economic growth well in excess of longer-term
potential. Fuelled by buoyant tourism, growth was particularly
strong in 2016, at 7.2%. It is predicted to be in excess of 6%
in 2017. The economy was probably already operating at full
employment in 2015. In spite of this, recent growth has been
associated with a relatively well-balanced economy, and the
looming risk of overheating has only partly materialised.

Inflation has been close to but below the 2.5% target for
well over three years, and inflation expectations converged
with the target from above in summer 2016. Since 2009, there
has been a significant current account surplus, which peaked in
2016 at 8% of GDP.

Positive supply shocks, benefits from cross-border economic
integration, and prudent macroeconomic policies have been key
to this somewhat unusual constellation of economic outcomes.
Growth in exports, improvements in terms of trade, and a shift
of the international investment position from highly negative
at the peak of the crisis to positive at the end of 2016 have
raised the equilibrium real exchange rate. It has therefore
been possible to accommodate large wage increases in recent
years and keep inflation close to target through a sizeable
nominal appreciation of the currency. Bottlenecks in the labour
market have been mitigated through record importation of
labour, which partly explains how the economy could grow
significantly in excess of longer-term potential. Finally,
monetary policy has been tight, with the nominal policy rate
currently at 4.5% and the real policy rate having fluctuated in
the 2.5%-3% range since early 2016. This stance was key to
bringing inflation expectations down to target and, along with
the market-driven nominal appreciation of the króna, has
prevented inflation risks from materialising.

The comprehensive controls on capital outflows that were
introduced during the crisis were mostly lifted in three major
steps in winter 2016/17. Over time, this will bring significant
efficiency gains.

However, small, open, and financially integrated economies
also face risks associated with large and volatile capital
flows, as Iceland learnt the hard way before the crisis. In
recent years, the Icelandic authorities have prepared the
economy and the financial sector for these risks by building
resilience and strengthening financial sector regulation and
supervision. The general government deficit that peaked at
almost 10% of GDP in 2010 was significantly reduced in the
following years and turned into a surplus in 2016. Public and
private sector debt has fallen significantly relative to income
since the crisis. Foreign exchange reserves are bigger than
ever and mostly financed domestically. The banks are well
capitalised, with an average leverage ratio of 17% at the end
of 2016. They must satisfy requirements concerning a special
liquidity coverage ratio and a net stable funding ratio in FX,
which significantly limits the risk in the FX part of their
balance sheets.

Parliament recently passed legislation enabling the
regulation of potential build-up of currency mismatches in the
private sector. A special reserve requirement on carry
trade-related capital inflows is currently in force, which
limits risks stemming from the accumulation of such positions
and creates more scope for monetary policy to keep interest
rates significantly higher than in the rest of world, as is
currently warranted by Iceland's strong relative cyclical
position. Finally, macroprudential oversight and tools are
being developed and activated.